Financial Instruments Derivatives Ppt MBA FINANCE

8/2/2019 Financial Instruments Derivatives Ppt MBA FINANCE

1/24

Financial Instruments

Money & Banking

-Derivatives

PRESENTED BY:-BABASAB PATIL


2/24

Content Outline1. Introduction

2. What is a derivative?

3. Reasons to use derivatives4. Concepts to understand

5. Futures

6. Forwards7. Options

8. Swaps

9. Questions


3/24

Introduction (I)In the financial marketplace some instruments are regarded as f u n d a m e n t a l s ,while others are regarded as d e r i v a t i v e s .

Financial Marketplace

Derivatives Fundamentals

Simply another way to catagorize the diversity in the FM*.

*Financial Market


4/24

Financial Marketplace

Derivatives Fundamentals

Stocks Bonds Etc.

Futures Forwards Options Swaps

Introduction (II)


5/24

What is a Derivative? (I)

Options

Swaps

ForwardsFuturesThe value of thederivative instrument is

DERIVED from theunderlying security

Underlying instrument such as a commodity, a stock, a stock index, an exchange

rate, a bond, another derivative etc..


6/24

Options

Swaps

Forwards

Futures

The owner of an options has the O P T I O N to buy or sellsomething at a predetermined price and is therefore more costlythan a futures contract.

The owner of a forward has the O B L I G AT I O N to sell or buysomething in the future at a predetermined price. The differenceto a future contract is that forwards are not s t a n d a r d i z e d .

The owner of a future has the O B L I G AT I O N to sell or buysomething in the future at a predetermined price.

What is a Derivative? (II)

A swap is an agreement between two parties to

exchange a sequence of cash flows.


7/24

Reasons to use derivatives (I)

Hedging:

Speculation :

Interest rate volatility Stock price volatility Exchage rate volatility Commodity prices volatility

VOLATILITY

High portion of leverage Huge returns

EXTREMELY RISKY

Derivative markets have attained an overwhelming popularity for a variety of reasons...


8/24

Reasons to use Derivatives (II)

Also derivatives create...

a c o m p l e t e m a r k e t , defined as a market in which all identifiable payoffs can be

obtained by trading the securities available in the market*.

and m a r k e t e f f i ci e n c y , characterized by low transaction costs and greater

liquidity.


9/24

Concepts to Understand

Short Selling: Short selling is the selling of a security that theseller does not own.

Short sellers assume the risk that they will be ableto buy the stock at a more favorable price thanthe price at which they sold short.

Holding Long Position:

Investors are legally owning a security.

Investors are the legal owners of a security.


10/24

Future Contracts (I)

Futures The owner of a future contract has the OBLIGATION to sell orbuy something in the future at a predetermined price.

Scenario: You are a farmer and you know that you will harvest corn in three months from

today on. How can you protect yourself from loosing if corn price happens to drop

until March by using corn forward contracts?

t1/1 3/1

Harvest


11/24

Future Contracts (II) You lock into a price by holding a short position in a corn future contract with a

maturity date a little bit longer than the harvest date.

Suppose the price drops...

You either take delivery andlock in a price.

You close out the corn contractand the gain in the futuresmarket will offset the loss in thesport market

A futures contract makes unfavourable price movements less unfavourable and a

favourable price movements less favourable!


12/24

Future Contracts (III)

General Rule for Hedgers:

If you are going to sell something in the near future but want to lock in a

secured price, you take a short position.

If you are going to receive/buy something in the future but want to lock in a

secured price, you take a long position.


13/24

Future Contracts (IV)

The Role of Speculators:

As the name implies, speculators are involved in price betting and take the risk of

price movements against them.

Assume the following: You, as hedger, believe that prices will raise. Thus, you are convinced that a long

position will benefit you.

Key Word: Zero-Sum-Gain

Large gains due to the concept of leverage


14/24

Forward Contracts (I)

Forwards The owner of a forward has the OBLIGATION to sell or buysomething in the future at a predetermined price. The differenceto a future contract is that forwards are not standardized.

A Forward Contract underlies the same principles as a future contract, besides the

aspect of non-standardization. Thus, a detail illustration is not necessary as I already

elaborated in the mechanism of the futures contract.


15/24

Options (I)

Options The owner of an options has the OPTION to buy or sellsomething at a predetermined price and is therefore more costlythan a futures.

Some terms to understand:

Call option

Put option

Excersice price / strike price

Option premium

Moneyness (in-the-money, at-the-money, out-of-money)

European vs. American Options


16/24

Options (II)

Call Option

Put Option

Write

Purchase

Write

Purchase

The four basic positions:


17/24

Options (III)Write & Purchase Call Option:

x

Long Call

Short Call

Value

Stock Price at Expiration


18/24

Options (IV)Write & Purchase Call Option:

Profit and Loss

xStock Price at Expiration

Long Call

Short Call

Premium Paid

Premium EarnedZero-Sum-Game


19/24

Options (V)Write & Purchase Call Option:

Profit and Loss


Long Put

Short Put


20/24

Options (VI)Write & Purchase Call Option:

Profit and Loss


Long Put

Short PutPremium Paid

Premium Earned


21/24

Swaps A swap is an agreement between two parties toexchange a sequence of cash flows.

Swaps (I)

Counterparties

Interest rate swaps

Currency swaps

Phenomenal growth of the swap market

Future and Option markets only provide for short term investment horizon

Traded in OTC markets with little regulations

No secondary market

Market limited to institutional investors


22/24

Swaps (II)

A Plain Vanilla Interest Rate Swap:

An interest rate swap is an agreement between two parties to exchange a sequenceof fixed interest rate payments against floating interest rate payments.

Fixed side

Receive-fixed side

Tenor

Notional amount

Terms to understand:


23/24

Swaps (III)Example:

5 year tenor; notional amount $1 million; Party A is the fixed side paying 9%, Party Bis the receive-fixed side, paying a LIBOR flat rate

0 1 2 3 4 5

0 1 2 3 4 5

$90,000 $90,000 $90,000 $90,000 $90,000

$90,000 $90,000 $90,000 $90,000 $90,000

Libor*$1m Libor*$1m Libor*$1m Libor*$1m Libor*$1m

Libor*$1m Libor*$1m Libor*$1m Libor*$1m Libor*$1m

Party A

Party B


24/24

QUESTIONS

Financial Instruments Derivatives Ppt MBA FINANCE

Documents

Transcript of Financial Instruments Derivatives Ppt MBA FINANCE